The business interest deduction has been a staple of the tax code for over a century. Deducting interest is important in home building, as debt is a critical financing tool and access to equity markets is challenging for the majority of home builders.
The new tax law alters the business interest deduction (BID) by placing a cap on the amount of interest a taxpayer may deduct. That’s the bad news. The good news is that an exception was made for real estate businesses.
The result is that if these businesses like the way the BID previously functioned, they may keep the deduction in full. If they would rather abide by the broad limitation on deductibility, they may opt out of this exception. The decision is particularly important as it locks a taxpayer into whatever treatment they choose indefinitely and comes with tradeoffs regarding the new depreciation rules.
The new limitation
In general, the new tax code limits the amount of deductible business interest expenses to 30% of earnings before interest, taxes, depreciation, and amortization (EBITDA). In 2022, the limit on deductibility is further restricted to 30% of EBIT. Thus, companies with large annual depreciation and/or amortization deductions will need to assess whether they can weather the new limit that will be imposed four years down the road.
Exception for small businesses
Paragraph 3 of the new “limitation on business interest” section states that the limitation shall not apply to any taxpayer meeting the gross receipts test of section 448(c). This effectively frees any business with less than $25 million in revenue (averaged over the prior three years) from the limitations. So while a real property trade or business with more than $25 million in gross receipts, on average, may elect to opt out of the limits (with some tradeoffs discussed below), any company below this threshold is fully exempt.
Consider a business with $30 million in revenue, $2 million in earnings before interest and taxes, $450,000 in interest expenses, and $600,000 in depreciation deductions. The initial limit on the BID does not actually change how much they can deduct, as $450,000 is less than $600,000 ($2 million x 30%).
However, come 2023, the business must subtract its depreciation costs (as well as amortization and depletion, if applicable) before calculating its limit. Thus, the limit for this business falls from $600,000 to $420,000 [($2 million minus $600,000) x 30%]. If paying the new corporate tax rate of 21%, this $30,000 decrease would increase their tax liability by $6,300 (a $30,000 increase in taxable income multiplied by 21%). Similar dynamics would apply to pass-thru businesses.
Real estate business defined
Section 13301 of the Tax Cuts and Jobs Act defined “real estate trade or business” quite broadly, using the text of passive activity loss rules (IRC Sec. 469):
“[T]he term ‘electing real property trade or business’ means any trade or business [as any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business] which makes an election [to keep the full business interest deduction].”
As mentioned above, the exception for real estate businesses comes with strings attached. First, if a business elects to keep the interest deduction without limitations, it cannot take advantage of so-called “expensing.” This temporary provision of the tax law allows businesses to depreciate the full cost of asset purchases in the first year.
Second, the election to opt-out of the new limitations is irrevocable. Thus, it is imperative that owners make this decision with an eye on the future. If the structure of the business’s financing and/or capital expenditures is likely to change, a decision that makes sense today may not make sense two years from now.
The role of section 179
Section 179 of the tax code allows small businesses to depreciate some or all of its purchases in the year they are made. Under prior law, a business could fully deduct capital costs up to $500,000 if total purchases did not exceed $2 million. The deduction was reduced dollar-for-dollar above $2 million until fully phasing out at $2.5 million in yearly capital expenditures. Not only did the tax law keep this small business provision, it made the deduction more generous and—unlike expensing which phases out after tax year 2026—made the new section 179 permanent.
The $500,000 limit has been increased to $1 million and the $2 million limit on total purchases was raised to $2.5 million. Thus, the deduction does not fully phase out until total capital expenditures (capex) reaches $3.5 million.
The bottom line is that if your business typically spends less than $1 million on capex, you are already getting the benefit of expensing. This means that, generally speaking, you can decide to keep the full business interest deduction without actually facing a tradeoff with more generous depreciation rules.
While deciding what option is best, business owners should keep in mind that real property (i.e. structures) must be depreciated using the Alternative Depreciation Schedule. For residential rental property, this means depreciating the cost over 30 years (3.33% per year) rather than 27.5 years (3.64% per year). Additional restrictions may apply depending on each taxpayer’s unique situation, but careful consideration of the items explained above should serve as a good place to start.
This article is for informational purposes only. It should not be considered tax advice. Before making any tax decisions, work with a tax professional. For more detail, please see the full disclaimer.